Bubble Diagnosis and Prediction of the 2005-2007 and 2008-2009 Chinese stock market bubbles

TL;DR

This paper applies the log-periodic power law model, combining economic theory, behavioral finance, and physics, to successfully detect and predict the timing of two major Chinese stock market bubbles and crashes between 2005 and 2009.

Contribution

It demonstrates the effectiveness and replicability of the LPPL model in predicting market bubbles and crashes in Chinese stock markets, extending prior success to new markets.

Findings

Successfully predicted the timing of two Chinese stock market crashes.

Validated the LPPL model's predictive power and replicability.

Extended the model's application to Chinese markets with consistent results.

Abstract

By combining (i) the economic theory of rational expectation bubbles, (ii) behavioral finance on imitation and herding of investors and traders and (iii) the mathematical and statistical physics of bifurcations and phase transitions, the log-periodic power law model has been developed as a flexible tool to detect bubbles. The LPPL model considers the faster-than-exponential (power law with finite-time singularity) increase in asset prices decorated by accelerating oscillations as the main diagnostic of bubbles. It embodies a positive feedback loop of higher return anticipations competing with negative feedback spirals of crash expectations. We use the LPPL model in one of its incarnations to analyze two bubbles and subsequent market crashes in two important indexes in the Chinese stock markets between May 2005 and July 2009. Both the Shanghai Stock Exchange Composite and Shenzhen Stock Exchange Component indexes exhibited such behavior in two distinct time periods: 1) from mid-2005, bursting in Oct. 2007 and 2) from Nov. 2008, bursting in the beginning of Aug. 2009. We successfully predicted time windows for both crashes in advance with the same methods used to successfully predict the peak in mid-2006 of the US housing bubble and the peak in July 2008 of the global oil bubble. The more recent bubble in the Chinese indexes was detected and its end or change of regime was predicted independently by two groups with similar results, showing that the model has been well-documented and can be replicated by industrial practitioners. Here we present more detailed analysis of the individual Chinese index predictions and of the methods used to make and test them.